Property

SIX

Managing Property

THE FORMS OF OWNERSHIP CONSIDERED in Chapter 5 involve a variety of divisions of ownership over time and among small numbers of persons at a given time. Yet, they all share this common feature: The person who is presently in possession of the asset has full managerial authority over it. Thus, when ownership is divided between a life estate and one or more remainders, the life tenant has full managerial authority over the resource as long as the life estate lasts. Once the life tenant dies, the holders of the remainders take possession, and they assume full managerial authority. At any point in time, the party in possession is the party in control.¹ Similarly, when property is divided among co-tenants, each of the co-tenants—in the eyes of the law at least—has full and equal authority to manage the property. The co-tenants may enter into some formal or informal agreement that confers managerial authority on one of the co-tenants, or prescribes some sharing of authority. But in terms of property rights, the law assumes that each has undivided managerial authority.

In this chapter, we consider some important legal devices that allow management authority over resources to be separated from other incidents of ownership. We will give specific attention to leasing, common interest communities, and trusts, each of which is regarded as creating a distinct form of ownership, and each of which plays an important role in modern economic systems.

Importantly, these are not the only legal devices for achieving a separation of management authority from other incidents of ownership. Perhaps the most important device, in terms of the total assets involved, is the business corporation. A corporation owns certain assets in its own name, such as factories, inventories, and intellectual property rights. The corporation is in turn owned by shareholders, who have a claim on the earnings of the corporation (through the payment of dividends), and on the assets of the corporation if it is dissolved. The shareholders, as the ultimate owners of the corporation, appoint directors who hire and oversee managers, who in turn run the corporation. (Directors and managers need not but typically do own shares of the corporation, but even where they do, their interest may be a tiny fraction of outstanding shares, as is typical in large publicly held corporations.) This arrangement allows management of the corporation’s assets to be separated from other incidents of the corporation’s property—namely, the profits and losses generated by those assets and the liquidation value of the assets.

The law of business organizations allows corporations (and related devices such as partnerships) to serve as pools of assets that creditors of the owners cannot reach: If Joe Shareholder misses a car payment, the corporation’s factory is not available to Joe’s creditors. And the creditors of the corporation cannot come after the shareholders personally. This “limited liability” means that if the corporation fails, Joe Shareholder’s stock might become worthless, but that is all he is on the hook for; his other assets are safe.

These business entities, however, are so important they are studied in separate courses. We will honor that convention here by largely ignoring them. It is important to remember, however, that the separation of management authority from other incidents of ownership can be achieved in multiple ways, including not merely the devices we consider in this chapter but also others, such as forming a corporation.

Why Separate Management Authority from Other
Incidents of Ownership?

Property by its very nature tends to concentrate authority over the management of resources. The logic of property is to assign each thing of value to an identifiable owner, who has the right to manage the thing to the exclusion of everyone else. Why then would people ever want to separate managerial authority from other incidents of ownership, such as the rights to possess, consume, or enjoy the profits from some thing? There are several reasons, including those related to financing and avoiding taxes. The most general explanation, however, involves achieving a specialization of functions in the management of resources. This specialization often requires aggregating resources—on some dimensions at least—to achieve the scale needed to support the introduction of specialized management. This aggregation is difficult to achieve solely through contracts among individual owners of smaller scale resources, because of collective action problems such as holdouts and freeriders. Leasing, common-interest communities, and trusts are all forms of property that permit aggregation on some dimensions—which creates the conditions for the introduction of specialized management on those dimensions—while maintaining separation on other dimensions. This explanation is best fleshed out with some examples, which will also serve to introduce the three forms of property we will consider in this chapter.

Consider, first, a shopping center, consisting of a complex of retail stores arrayed in a single building, together with common facilities such as a heating plant, landscaping, a parking lot, and security guards. One way to organize such a shopping center would be to have one person (most likely a corporation) own and manage all the assets in the complex. This single owner-manager strategy has advantages and disadvantages. The principal advantages are that common facilities can be effectively managed and maintained by the single owner. The disadvantages are those characteristic of any large enterprise. It may be difficult to supervise employees, such as retail clerks, in many different shops, and the shopping center may take on a dull homogeneous aspect lacking appeal for many consumers. Another way to organize the shopping center would be to have each store owned and operated independently of the others, the way downtown shopping areas have traditionally been organized. This multiple owner-manager strategy also has advantages and disadvantages. The advantage is that the individual shops can better supervise employees and will exhibit greater variety and responsiveness to consumers. A principal disadvantage is that fragmentation of ownership creates a huge collective action problem. Who will be in charge of providing heat and maintaining the parking lot? Who will provide security services? Who will maintain the landscaping? It would be difficult if not impossible for the individual shop owners to agree on contracts in which they mutually agree to provide such services.

A better solution, which avoids many of the drawbacks of both the single-owner and the multiple-owner strategies, is to use leasing to overcome the collective action problem while retaining individual managerial authority over the individual shops. Under such an arrangement, one party—the owner of the complex as a whole—owns and controls the common facilities, such as the building, the landscaping, and the parking lot, and is responsible for providing security for the whole complex. This solves the collective action problems associated with multiple owners. The individual store spaces are then leased to different shopkeeper-tenants, each of whom is responsible for management of their own individual space. Thus, each individual shopkeeper-tenant decides, independently, how to design the interior space of each shop, what inventory to purchase, and how to compensate and supervise employees. This solves many of the problems of bureaucracy, employee supervision, and homogeneity associated with the single-owner strategy. Given the division of functions permitted by leasing, it is not surprising that this device is almost universally used in the organization of shopping centers.

Our second example is a real estate development consisting of many freestanding single-family homes clustered around some common facility such as a boating marina, a ski resort, a golf course, or an ecological preserve. Here again, we can imagine both centralized and decentralized ways of organizing such a community. One could organize the common interest community under the auspices of a single owner, with the owner managing all the assets and assigning homes to individual families by contract. This would likely tend toward excessive rigidity and homogeneity and would not give individual families control over the design and maintenance of their assigned homes. Alternatively, one could organize the community as a collection of independent homes, relying on contracts among homeowners to support the common facilities. But this would generate potentially insuperable collective action problems if individual homeowners refused to contribute to the common undertaking or otherwise failed to cooperate with each other.

Today, the dominant way to organize such a common interest community is by creating a homeowners’ or community association to govern the common facilities, with the individual homes owned as condominiums or in fee simple subject to a package of servitudes running with the land. The homeowners’ or community association functions like a private government, with a constitution, laws, an elected governing board, and periodic meetings of unit owners to vote on actions of general interest. Most importantly, the homeowners’ or community association is given the power to collect monthly assessments from the homeowners to pay for the ongoing provision of the common facilities. Meanwhile, the individual homes are managed by each individual homeowner, subject to restrictions about exterior decoration and upkeep, and perhaps other matters such as keeping pets. As in the case of the shopping center, we can see that the common interest community is a device for overcoming collective action problems to provide for a specialization of functions.

Our third example involves a problem in the transmission of family wealth from one generation to the next. Suppose the family breadwinner, B, is suffering from a fatal disease and does not expect to live much longer. B’s spouse, S, has limited ability to earn income, and has recently battled with cancer, which is in remission and may or may not return. B also has three children from a prior marriage. The eldest, E, is independent, has a well-paying job, and is in good health. The middle child, M, is still in college and is trying to decide between a low-paying but personally gratifying career and a much higher-paying career. The youngest child, Y, suffers from a variety of behavioral problems including drug abuse and has been in and out of group homes for years; it is unclear whether these problems will be resolved. B has accumulated substantial savings, and would like to leave the money in such a way as to provide the greatest benefit in the future to the four people B cares most about—S, E, M, and Y.

If the only options were those presented by the system of estates in land considered in Chapter 5, then none of the options is entirely satisfactory. B could leave a will that splits the property into four shares with each survivor owning his or her share in fee simple. But this might leave S with insufficient funds for future cancer treatments, or for M, if M elects the low-paying career option, or for Y, if continued treatment for behavioral problems is required. Moreover, B is likely to be concerned that some of the beneficiaries, such as Y, are not capable of managing the assets, and could fritter the money away or use it for undesirable purchases like drugs. Alternatively, B could leave a life estate to S, with remainders to E, M, and Y. But S might live a very long time, or might remarry, and in either event might not want to devote any of the money for the support of M and Y, if they need it before S dies.

What B needs is a faithful and competent manager for the assets, who can invest and dispose of the funds in the future in approximately the way B would have done if B were still alive. The principal method for doing this today is to create a trust. This allows legal title to the funds to be transferred from B to a trustee, T, either immediately or upon B’s death. If T is a corporate trustee, such as a bank trust department, then the funds can be combined with other trust funds and invested in a portfolio of investments, diversifying risk and improving the expected return. Meanwhile, T is subject to strict duties of honesty, prudence, and other fiduciary duties in the management of the funds (see below), and can be given detailed instructions about how to distribute the funds among S, E, M, and Y, depending on future contingencies. Once again, we can see how the trust overcomes collective action problems in a way that allows for a separation of management authority from other incidents of property and thereby permits a specialization of functions in the use of the property.

Leasing

Let us give closer consideration to the first of these devices for separating management authority from other incidents of ownership—leasing. Leasing is a very old form of ownership and continues to be used in a wide variety of circumstances. It goes by a variety of names: leasing, leaseholds, renting, tenancies, landlord-tenant relations—all are essentially synonymous. We will refer to the relationship between lessor and lessee as “leasing,” the specific contractual undertaking between the lessor and lessee that governs their relationship as the “lease,” and the property rights the lessee acquires under the lease as the “leasehold.”

The essence of leasing is simple. A property owner—the lessor or landlord—agrees to transfer possession of property to another person—the lessee or tenant—for some time period. In return, the lessee agrees to pay the lessor rent, nearly always at periodic intervals. Leasing is similar to bailments in that it entails a temporary transfer of possession of property. It differs in that the purpose of a lease is to convey full economic use of the transferred item to the transferee, whereas in a bailment, the item is transferred for a limited and specific purpose such as repair or safekeeping. Leasing is also similar to the life estate in that the transfer of possession entails temporary but full economic use of the asset. However, the time period in a lease is nearly always described in terms of months and years rather than natural lives as in the case of a life estate.²

Leasing also differs from both the bailment and the life estate in that the transferee agrees to make periodic payments of rent to the transferor. Because the lessor expects to receive rental payments, the lessor is inevitably much more involved in monitoring the behavior of the lessee than is typically the case with someone who has entrusted property to a bailee or who has transferred property in a life estate subject to a reversion. The lessor will want to know, at a minimum, if the lessee has abandoned the property, which would have dire implications for future payment of the rent. Moreover, the lessor is likely to keep an eye out for other signs of trouble, such as prolonged illness or unemployment or a closing of the lessee’s business. In effect, the lessor’s expectation of periodic rental payments will naturally incline the lessor to a more interactive relationship with the lessee than will be the case as between a bailor and a bailee or a life tenant and a holder of a reversion. The continued engagement of the lessor in overseeing the property also allows leasing to be used to achieve a division of functions between lessor and lessee, as previously discussed in connection with the shopping center example.

Leasing covers a wide variety of situations and includes both real and personal property. There are very long so-called ground rent leases of 99 years or more for land on which tenants construct and own their own buildings; leases of agricultural land; leases of commercial space in office buildings or shopping centers; leases of unfurnished houses and apartments; short-term month-to-month leases of furnished apartments; and leases of computers, automobiles, airplanes, and machinery. The fact that leasing occurs in so many different contexts confirms the great utility of this property form.

Leases are sometimes divided into different types depending on the rules for determining when they terminate. A term of years terminates at a point in time predetermined in the lease. This can be measured in years, months, or even by a particular day. At common law no notice was required by either party to terminate a term of years on the day appointed, although this has been modified in many states by statute. A periodic tenancy rolls over automatically from one time period to the next, unless one of the parties gives notice of termination, usually a month in advance. A tenancy at will continues indefinitely, until one of the parties decides to terminate. At common law no notice was required. Finally, a tenancy at sufferance is created when a tenant holds over after the termination of a lease. Such a tenant has greater rights than a trespasser, but is obviously subject to eviction by whatever procedures the law allows.

Property and Contract

At the heart of every lease is a bilateral exchange: the transfer of possession of some resource, whether it be land, an apartment, or an automobile, for a designated period of time, in return for a promise to pay rent. Leasing thus includes both a contract—the agreement between the lessor and lessee called the lease—and a transfer of possession of the resource that is the subject matter of the lease. In its contractual aspect, leasing affects primarily the relations between the lessor and the lessee. The contractual aspect is in personam, in the sense that it creates personal rights and duties between the lessor and lessee and does not directly impact the rights and duties of third parties.

Yet the interest of the lessee, although grounded in contract, also has the critical features of a property right: The lease transfers possession and full economic use of the resource to the lessee. As is usually the case, the right of possession includes the right to exclude others from the property possessed. Absent agreement to the contrary, this includes the right to exclude the lessor. Thus, the lessee acquires primary managerial authority over the thing leased during the term of the lease. The lessee can decide who may or may not enter or use the property, how the property will be used, and so forth. Two caveats should be noted about this property right. First, the managerial authority of the tenant can be and often is cabined by provisions in the lease. For example, the lease can say “no pets” or can allow the landlord to enter and inspect the property at certain times. Second, as previously discussed, leasing is often used to achieve a division of functions, so that, in the case of an apartment lease for instance, the tenant has authority over the interior space but the landlord retains managerial authority over common areas such as the building shell, lobby, elevators, and the heating system.

Because the lease transfers possession and economic use of the property to the lessee, the lessee ordinarily assumes the risks and benefits associated with ownership of the leased property, such as crop failure, a surge or decline in profitability, or liability for injury to third parties, during the term of the lease (again, subject to specific modifications in the lease). This is very important in understanding the economics of leasing. The lessor’s economic interest during the term of the lease is in receiving the rental payment, which is typically fixed by the contract. The lessee’s interest is based on receiving the benefits of possession, which can fluctuate depending on the state of the economy and other external factors, but also on the level of effort and skill the lessee puts into managing the property during the term of possession. The lessee is thus the “residual claimant” in a leasehold arrangement during the term of the lease, meaning the lessee captures the value left over after other obligations are met, including of course the obligation to pay rent to the lessor.³ The lessee’s status as residual claimant creates a powerful incentive for the lessee to engage in good managerial practices over the leased property during the term of the lease.

After the term of the lease, the landlord reclaims possession of the premises. Thus, in addition to an expectation of the rental payments during the lease the landlord also holds a reversion. As with the temporal split between present possessory and future interest holders we saw in Chapter 5, the tenant’s incentives are biased toward present consumption and against investments that produce benefits beyond the lease term. Conversely, landlords are interested less in the present and more in the future. Not surprisingly, the law of waste can be invoked on behalf of the landlord, but because leases are typically of shorter duration than a life estate, the standard in landlord-tenant law is that the tenant must return the premises in the condition at the beginning of the lease except for “normal wear and tear.” As was the case with present and future interests, the standard provided by the waste doctrine is a default, and here can be varied in the lease itself.

Most legal issues regarding leasing concern its contractual aspect. As with most contractual relationships, the rules that govern leases are primarily default rules. This means the parties to the lease are free to specify some alternative rule in the lease if they do not wish to abide by the off-the-rack legal rule. Leasing performs so many different functions that it might be sensible to use different packages of default rules for different types of leases. What makes sense as a default rule for agricultural leases does not necessarily make sense for commercial leases, which in turn may not make sense for residential leases. But for better or worse, the common law has sought to identify a single package of default rules for all types of leases. Legislation in many jurisdictions has changed some of the default rules based on the type of leasing involved. For example, in the context of residential leases, but not generally for commercial leases, the default rule regarding risk of destruction of a building during the term of the lease has been shifted from the tenant to the landlord by legislation in most states. These interventions, however, have been ad hoc and do not reflect a systematic package of defaults that varies by type of lease.

A good example of the contractual nature of leasing law concerns what happens if the leasehold commences, and another tenant (or a trespasser) is in possession of the property. Who is responsible for evicting the holdover tenant or the trespasser at the onset of the leasehold—the landlord or the tenant? Jurisdictions are divided on this issue.⁴ Those that follow the so-called English rule imply a covenant requiring the landlord to deliver actual possession. Those that follow the American rule say there is no such implied covenant, and the tenant has the obligation to remove the holdover or the trespasser. A number of jurisdictions adopted the English rule as part of the pro-tenant trend in landlord-tenant decisions in the 1970s, making it the majority rule for residential tenancies today. In either case, the rule is a default, meaning that the parties can override the rule and can specify in the lease which party is obligated to deal with holdovers or trespassers at the beginning of the leasehold.

Following the standard analysis of default rules in the law of contracts, the better default rule is generally the one most parties would want. This “majoritarian” approach minimizes the need for drafting around the rule. Here, the rule most parties would want is probably the one that saves the most on costs spent on evicting holdovers or trespassers. The rule that saves costs means the parties have more joint wealth to share, making them collectively better off. Unfortunately, neither of the contending rules may conserve on eviction costs in every situation. The identity of the cheaper evictor probably depends on the type of leasehold. For rentals of urban apartments, where the landlord is either on the property or has a manager on the property, and where the landlord is familiar with the prior tenant and with eviction procedures, the landlord is almost surely the cheaper evictor. For leases of agricultural land, where the tenant is likely to be familiar with the area and the identity of the prior tenant, and the landlord may be an absentee, the tenant may be the cheaper evictor. This illustrates the difficulty of having a single set of default rules that apply to all types of leases. It also may explain why the jurisdictions are divided as to the proper rule.

Models of the Lease Contract

If leases were always construed like ordinary bilateral contracts for the sale of goods or services, there would be little reason to study the contractual aspect of leasing as a distinct topic. Lease law would simply be an application of ordinary contract law. Unfortunately, things are not so simple. Lease law initially developed at a time when contract law was different from what it is today. Perhaps because of heightened respect for stare decisis in matters involving property rights, courts have been slow to update the understanding of the contractual aspect of leasing law. One can distinguish three phases in the evolution of the contractual model in lease law.⁵

The first phase conceived of the lease as a bundle of independent covenants or promises. Take a very simple lease in which L promises to transfer possession of Blackacre to T for three years, and in return T promises to pay L $100 per year in rent. The promise to provide possession and the promise to pay rent were originally regarded as independent of each other. Thus, if a foreign invader seized Blackacre, ousting T from possession, T was still obligated to pay rent to L.⁶ Or, if T stopped paying rent, L was still obligated to provide T possession. The remedy for breach of any of the independent covenants, as was generally the case in actions at common law, was an award of damages. The one exception to this rule was if the landlord breached the so-called covenant of quiet enjoyment—the promise to provide possession to the tenant—by ousting the tenant during the term of the lease. Ouster by the landlord excused the tenant from further payment of rent, until the ouster was cured.

The model of independent covenants had a number of harsh consequences for both landlords and tenants. If the tenant abandoned the property and stopped paying rent, the model required the landlord to let the property stand idle while periodically suing the tenant for damages—often to no avail if the tenant was insolvent or had disappeared. Or, if the landlord breached covenants regarding the condition of the property, such as a covenant to provide heat, the tenant’s only recourse was to shiver and sue for damages.

In the second phase of the evolution of leasing law, which we can call the transitional model, courts and legislatures responded to these sorts of problems by adopting rules and doctrines designed to ameliorate the harshness of the independent covenants model, without abandoning its logic. The transitional model developed several rules that remain important today. To provide relief to the landlord faced with a defaulting and potentially insolvent tenant, courts permitted landlords to insert clauses in leases that allowed landlords to reenter and relet property upon default by the tenant. In effect, the landlord could elect to terminate the lease in the event of default. To cut off the tenant’s liability for rent when the tenant had abandoned and the landlord took steps to reenter, courts developed the surrender doctrine. This treated certain actions by the landlord, such as accepting the keys when proffered by the tenant, as an implied release of further liability for rent. Again, surrender acted as a form of termination of further lease obligations. And to provide some relief to tenants faced with intolerable conditions created by a landlord’s breach of a covenant to repair, provide heat, or control the behavior of other tenants, the courts developed the doctrine of constructive eviction. This built on the rule that breach of the landlord’s covenant of quiet enjoyment would excuse further payment of rent, by holding that landlord breaches that made conditions so intolerable as to require the tenant to vacate were tantamount to an actual eviction. This doctrine, too, effectively permitted early termination of the lease.

Beginning in the middle years of the twentieth century, a third phase developed, in which courts began to conceptualize leases as ordinary bilateral contracts, in which promises are regarded as being mutually dependent. Under modern contract law, a material breach by one party—nonperformance that is significant enough to count as a failure of a condition of the exchange—gives rise to a variety of remedial options for the other party, including rescission of the contract. Applied to leases, this would mean, for example, that if the landlord promised to maintain an elevator in good working order, and it remained broken for some time, the tenant could argue that this was a material breach justifying rescission by the tenant; that is, the tenant could walk away from the lease without liability. Adoption of modern contract law would also mean that a duty to mitigate damages would be implied in all leases. This would mean that a landlord would have a legal duty to seek a substitute tenant in the event of abandonment by the original tenant. Perhaps most significantly, modern contract law might suggest that leased property includes an implied warranty of fitness for the tenant’s intended purpose, by analogy to contracts for the sale of goods.

Although the third phase in understanding the contractual aspect of leases has made substantial inroads, it has failed completely to vanquish the rules developed in the first two phases. Adoption of the third model remains selective. For example, in many states the duty to mitigate damages applies to residential leases, but not to commercial leases. Similarly, in most jurisdictions there is an implied warranty of habitability that applies to residential leases, but there is no implied warranty of fitness for intended purposes in commercial leases. Moreover, even where the third model has been expressly adopted, courts tend to allow parties to plead doctrines developed in the second or transitional phase in the alternative. For example, a residential tenant can allege breach of the implied warranty of habitability (a third-phase doctrine) and constructive eviction (a second-phase doctrine) in the alternative. As a result, the contractual aspect of lease law, which in principle could be simple and little different from ordinary contract law, is highly complicated and contains many elements unique to lease law.

Implied Warranty of Habitability

Perhaps the most controversial development in leasing law in recent years has been the widespread adoption of an implied warranty of habitability in residential leases. As noted above, during the transitional period between the model of independent covenants and the modern trend toward adoption of dependent covenants, courts developed the doctrine of constructive eviction. This relieved tenants of all liability under the lease if the conditions of the premises deteriorated so badly that the landlord had in effect ousted the tenant. The doctrine generally required tenants to abandon the property to claim constructive eviction, which obviously posed very severe risks for the tenant. If the courts concluded that constructive eviction had not been established, then the tenant could be held liable for all rent due and owing during the period when the tenant was out of possession. There is also confusion in the case law about whether the tenant must prove the breach of some specific lease provision by the landlord, such as a covenant to repair or provide heat, to establish constructive eviction, or whether it is enough that conditions are so bad that any “reasonable” person would be forced to vacate.

In addition to constructive eviction, other doctrines developed in the transitional period also provided some relief for tenants. If the landlord knew or should have known about some defect in the condition of the property, and failed to disclose this to the tenant before the tenant took possession, some courts permitted the tenant to sue on grounds of fraud or implied misrepresentation.⁷ Also, leases of furnished houses or apartments for short terms have long been held to include an implied warranty of habitability.⁸ Generally speaking, however, unless constructive eviction or one of these narrow doctrines applied, courts in the transitional phase applied a rule of caveat lessee—let the tenant beware.

In a brief period beginning in the late 1960s, nearly all states overturned the rule of caveat lessee and replaced it with an implied warranty of habitability (IWH), at least for residential leaseholds. Two distinct legal theories were advanced in support of this rapid revision in leasing law.⁹ One relied on the adoption of housing codes after World War II by most municipalities. Courts reasoned that the codes were intended to define the minimal quality of rental housing in the community, and that every lease is conclusively assumed to incorporate the provisions of the code as implied lease terms. The other theory relied on the development of products liability law and the extension of tort liability to manufacturers for defects in products they sell, even if the product has passed into the hands of someone with whom the manufacturer has no direct contractual relationship. Products liability, in effect, imposes an implied warranty of quality that runs with the product, and courts reasoned that a similar warranty should be implied in residential leases.

Both theories present a number of unresolved issues, many of which have not been addressed by courts. What exactly does the IWH guarantee? Under the housing code theory, the provisions of the codes would seem to define the duty, but some codes are highly precise, and others are vague and general. Much residential housing, especially in rural and unincorporated areas, is not governed by any code. Does this mean this housing is not subject to the IWH? Courts have said that not every code violation violates the duty, only “material breaches” that affect health or safety, and that judges have “wide discretion” in determining whether the conditions in any given rental unit amount to a material breach.¹⁰ The products liability theory provides even less guidance. As precedents slowly accumulate, the content of the warranty should become clearer, but local conditions (custom again) make variation inevitable, and prevent relying on precedents from other jurisdictions as sure guideposts.

The IWH also fits awkwardly with the modern trend to construe leases as ordinary bilateral contracts. The fit would be good if the IWH were regarded as a default rule, subject to disclaimer in the lease by the parties. In the context of sales of goods, there is generally an implied warranty of fitness for intended purposes. But sellers of goods are permitted to disclaim this warranty by specifying that the good is being sold “as is”; significantly, the same rule applies under the Uniform Commercial Code for leases of personal property (such as cars or equipment).¹¹ Most courts and legislatures that have adopted the IWH for residential housing, however, have insisted that the warranty is not disclaimable, but rather is binding on landlords and tenants alike. This is in keeping with the housing code and products liability theories, because neither public regulations nor tort duties to third parties can be disclaimed by contract. Perhaps the best contractual analogy is consumer protection law, where we do sometimes find nondisclaimable terms designed to protect relatively uninformed consumers. But like consumer protection law, nondisclaimability creates a disconnect between leasing law and the law’s general treatment of other bilateral contracts.

At a policy level, a number of justifications have been offered for the binding and nonwaivable IWH. Perhaps the one that enjoys the widest support is asymmetric information. In a typical residential tenancy, the landlord knows more about the condition of the property than a prospective tenant, and the landlord ordinarily has better information about the requirements of the law and the meaning of the provisions of the lease (which in residential tenancies is nearly always drafted by the landlord). By guaranteeing a minimal standard of quality, and making this nondisclaimable by fine print in the lease, the IWH corrects for this asymmetric information. The idea is that if both parties were fully informed, the tenant would insist on, and the landlord would agree to, a lease that includes the IWH.

More controversial is the idea that the IWH is justified because of unequal bargaining power between landlords and tenants. Unequal bargaining power is an ambiguous concept, and in many applications it may simply refer to asymmetric information, already discussed. To the extent it goes beyond the idea of asymmetric information, the unequal bargaining power rationale may depend on the vacancy rate in the relevant market. If the vacancy rate is low, then there will be many prospective tenants chasing few available units, and landlords will be in a position to drive hard bargains, including disclaiming any warranties of quality. If the vacancy rate is high, which is not unheard of in cities where developers have overbuilt or population is declining, then landlords will be in a weak bargaining position and may be willing to be flexible about lease terms. Many of the cases and commentaries assume that vacancy rates are always low, especially for low-income tenants. This is probably a safe assumption in cities where new residential housing construction has been restricted—either by limited available land, or strict zoning laws, or rent controls, or some combination of these factors (New York City suffers from all three). But in other cities and towns, such as those experiencing falling population, the assumption is open to question.

Another way to think of unequal bargaining power is to ask whether landlords have market power, in the sense of being able to affect prices by adding or withdrawing units from the market. If so, we would expect them to raise prices to supracompetitive levels. But whether such a monopolist would choose to lower quality as opposed to reducing supply and raising prices is more doubtful, quite apart from the problem of identifying the relevant localized market power in the first place. If regulators had perfect information about such localized market power (if any), they could use devices, such as rent control and conversion control, to prevent artificial supply restriction on the part of the monopolist, or regulate the quality dimensions furnished by the local monopolist under a fine-grained version of the IWH. But the informational assumptions here seem quite heroic.

The most controversial justification for the binding IWH is that it makes low-income tenants better off, and hence produces a more equitable distribution of wealth. This justification is highly debatable if the IWH is introduced in a rental market where landlords are otherwise free to make compensating adjustments, such as raising rents or withdrawing units from the market. If the IWH increases the quality of housing, demand for units may go up, and rents may increase. Alternatively, if coming into compliance with the IWH costs landlords money, the supply of housing may decline, through conversions to condominiums or abandonment, also causing rents to increase. If either or both of these forces is in play, then the question becomes whether the improvement in housing quality is worth more to low-income tenants than the higher rents they must pay. Various elaborate arguments have been advanced as to why ordinary laws of supply and demand may not apply in the rental housing market, but the question in the end is an empirical one.¹² Some tenants may gain from the IWH, but others, who cannot afford to pay more for housing even if the quality is higher, may lose. No one has yet demonstrated that the gainers outnumber the losers—or vice versa. Nor do we have any clear idea how large the relevant gains and losses are.

Perhaps the most unsettling aspect of the IWH is that it is not clear whether the change has had much impact on the welfare of low-income tenants. Appellate decisions interpreting the IWH are few in number, as compared to, say, decisions explicating products liability law. Litigation is expensive, and the amount in controversy in most cases involving an alleged breach of the IWH is small. Given the many uncertainties about the IWH, the absence of appellate decisions suggests either that most cases settle, or tenants do not assert IWH claims very often. If a high rate of settlement is the explanation, then the IWH may have some impact, even if it does not show up in reported appeals. If tenants simply do not assert the IWH very often, then the doctrine is probably not having much impact. Here too, it would be useful to have more empirical information.

Transferring Leasehold Interests

With a few prominent exceptions like the mandatory IWH in residential leases, the modern conception of the landlord-tenant relationship is very much like that of an ordinary bilateral contract. This means the lease can contain virtually any sort of promise the parties want it to contain: The landlord can promise to shine the tenant’s shoes, and the tenant can promise to walk the landlord’s dog. If either the landlord or the tenant transfers their interest to a third party, however, we see a significant shift toward standardization of the respective interests.

Suppose the landlord sells the reversion to a third party. The ordinary rule here is that the third party will take “subject to” any unexpired leases. Does this mean that if the original landlord promised to shine the tenant’s shoes, the new landlord must continue to shine the tenant’s shoes? Probably not: The common law rule is that only promises in the original lease that “touch and concern” the land run to successors in interest. This mysterious requirement is hard to define with any precision; basically what it means in this context is that only those terms in the lease that affect the scope of the property rights or the condition of the land are binding on successors in interest. Promises by the landlord to provide a parking place for the tenant and heat for the building would touch and concern the land; a promise to shine the tenant’s shoes probably would be regarded as a personal promise that does not run with the land.

Suppose the tenant decides to transfer the tenant’s remaining interest under the lease. The common law rule here is that absent an agreement in the lease to the contrary, the tenant’s interest is freely alienable. The landlord will often be concerned about who the tenant might transfer to; at a minimum, the landlord will want assurance that the new tenant is a good credit risk. Landlords are therefore free to include a clause in the original lease providing that the tenant may not transfer without the landlord’s permission. Historically, these permission clauses were understood to give the landlord complete discretion in deciding whether or not to permit a transfer, unless the tenant negotiated for additional language stating that consent to transfer will not be “unreasonably withheld.” Some jurisdictions have recently rejected this interpretation, however, and have ruled that a permission clause will be construed to mean the landlord must have a commercially reasonable ground for withholding consent, unless the landlord has negotiated for additional language stating that consent can be withheld for any reason.¹³ This may well be a better default rule and prevents the landlord from extracting gains in the market value of leases that some tenants legitimately expect to capture. Nevertheless, since most lease transfers involve long term commercial leases where both parties are represented by counsel, it is not clear that tinkering with the default interpretation of permission clauses in this fashion is worth the disruption to settled expectations.

Tenant transfers are subject to a further type of standardization, in that they can be achieved in only two ways: through assignment or a subletting. An assignment occurs when the tenant transfers the entire remaining interest in the lease to a third party, such that the new tenant steps into the shoes of the original tenant. When this happens, the original tenant is still liable to the landlord under privity of contract—for the obligations set forth in the original lease (including the obligation to walk the dog). But the new tenant now holds directly from the landlord, and so is said also to be obligated to the landlord under “privity of estate.” This means the new tenant must perform all obligations of the original lease that “touch and concern” the land, in exact parallel to what happens when the landlord sells the reversion to a third party. So the new tenant has to pay the rent to the landlord, but probably does not have to walk the dog.

A sublease occurs when the tenant does not transfer the entire remaining interest in the lease to a third party, but retains some interest for him or herself. For example, if the lease has one year to run, the prime tenant could transfer the summer months to a third party but then retain the last nine months for him or herself. When this happens, the prime tenant remains obligated to the landlord under privity of contract and hence must perform all the provisions of the original lease (including walking the dog). But in a clear echo of feudalism, the subtenant is regarded as holding of the prime tenant, not of the landlord. Consequently, there is no privity of estate between the landlord and the subtenant, and the landlord cannot enforce any of the obligations of the original lease against the subtenant. This includes the obligation to pay rent. If the subtenant defaults on the rent, the landlord’s only recourse is against the prime tenant.

Courts have devised a variety of tests for distinguishing between assignments and subleases, but the basic question is whether the original tenant is still in the picture or has transferred everything to the substitute tenant. The more significant point is that there are only two ways to transfer—assignment or sublease—and courts do not recognize any other arrangement. This is another example of the numerus clausus principle at work, and can be understood as reducing the information costs about the rights and obligations of the respective parties that third parties (such as creditors or other prospective tenants) would have to bear if a larger menu of options prevailed.

Common Interest Communities

Leasing, as we have seen, is often used to achieve a division of managerial authority between common and separate facilities within a single complex of assets. Common interest communities are also used to achieve a division of managerial authority between common and separate facilities within a single complex of assets. The basic concept of a common interest community is that individual units, whether they be apartments or townhouses or freestanding homes, are usually owned in fee simple by individual owners. The individual unit owners then collectively organize themselves to manage certain common or shared facilities, whether it be the exterior shell, lobby, and heating plant in an apartment building, or swimming pools, driveways, and landscaping in a complex of buildings. Familiar examples of common interest communities include condominiums, cooperative apartments, and gated residential developments. Virtually every common interest community could also be organized by leasing (although leasing has broader applications, as in ground rent leases). Hence, common interest communities are an alternative choice for achieving one of the principal functional ends of leasing.

Common interest communities take one of two legal forms, both of which are expressly authorized by statute. In a condominium, individual units are held in fee simple and common areas and facilities are co-owned by the unit owners (without a right of partition). Unit owners are typically required to be members of a condominium association, which governs the common facilities. In a cooperative, individual units and common facilities are owned by a single entity, the cooperative corporation. Individuals then purchase shares in this corporation, which shares entitle them to a perpetual lease of a particular unit.

Under either of these legal forms, common interest communities function in practice as a kind of private government.¹⁴ Such communities are nearly always created by a single person or entity, typically a real estate developer (analogous to the founders of a new political entity). The developer will incorporate the plan for the common interest community in promises that are included in the deeds to the land and that run with the land (more on promises running with the land in Chapter 8). These deed promises are sometimes called covenants, conditions, and restrictions (CCRs). These promises provide the basic framework for the management of the common interest community (analogous to a constitution or city charter), and are binding on the managers of the common or shared facilities and the individual unit owners alike. The CCRs will typically provide that the individual unit owners constitute a homeowners’ association (HOA), which will gather periodically or on special occasions to vote on matters of common concern to the community (analogous to the electorate of a state or city participating in elections or referenda). The CCRs will also typically provide for a governing board, which is in charge of managing the common or shared facilities and enforcing rules and regulations that control the behavior of the individual unit owners (analogous to a legislature or city council). Typically, the board consists of individual unit owners elected at a meeting of the HOA. The board may hire a manager (analogous to a city mayor or manager) and other employees to manage the common or shared facilities, or may enter into contracts with outside firms to provide these services. Importantly, the HOA will have the power to impose periodic assessments on the unit owners to cover the costs of providing common or shared facilities and services (analogous to taxes).

Given these organizational features, it is possible to describe the differences between leasing and common interest communities as being similar to the differences between dictatorship and democracy. Consider a residential complex consisting of a number of buildings containing multiple units, along with common facilities such as a swimming pool, recreation center, parking lot, and landscaping. If the complex is organized by leasing, the landlord has exclusive managerial authority over the common or shared facilities. The landlord can dictate what hours the swimming pool is open, whether free aerobics classes will be held in the recreation center, how often the parking lot will be resurfaced, and so forth. If the complex is organized as a common interest community, the common or shared facilities will be managed by the HOA or the governing board elected by the HOA. The HOA or the board will decide, typically by majority rule, what hours the swimming pool is open, whether free aerobics classes will be held, and how often the parking lot will be resurfaced.

The distinction between dictatorship and democracy must be qualified, however, because there are other important constraints that operate in both contexts. The landlord is constrained by the terms of the leases entered into with individual tenants and by legal duties such as the IWH. If the landlord agrees in the leases to keep the swimming pool open until midnight and to provide free aerobics classes, then the landlord will be contractually bound by these commitments. And the landlord cannot allow the property to descend into unsafe and unsanitary conditions without running the risk of liability under the IWH. Similarly, the CCRs in the common interest community may include promises that run with the land and constrain the discretion of the homeowners’ association and the board. If the CCRs include promises about the hours of the swimming pool, aerobics classes, and so forth, then the HOA and the board will be bound by these promises.

Also, both the dictatorial landlord and the majoritarian HOA will be constrained by market forces. If the landlord refuses to resurface the parking lot, and huge potholes develop, tenants may decline to renew their leases and the landlord may have trouble attracting new tenants. Similarly, if the board in a common interest community refuses to raise assessments to pay for resurfacing the parking lot, unit owners may suffer damage to their cars and the market value of their units may decline. Once a majority of the unit owners decides the board has been too stingy about the parking lot, this will predictably lead to a change in policy by the HOA or the election of new board. In short, the persons who occupy individual units in a leased complex have exit options, and the persons who occupy individual units in a common interest community have voice options.¹⁵ The explicit or implicit threat of exercising these options constrains whoever is exercising managerial authority over the common or shared assets.¹⁶

The percentage of residential property in common interest communities has increased steadily in recent decades, to the point where in many states today, more than one-half of new residential construction is organized in this fashion. What accounts for the surging popularity of this mode of dividing managerial authority over residential housing? The most general explanation is that people increasingly want the advantages of a division of managerial authority. Whether it be common facilities such as swimming pools or golf courses, or the economies of scale involved in sharing expenses for exterior maintenance, landscaping, and security services, the division of functions made possible through the use of a common interest community provides many benefits that plain ownership does not. Given that such a division of authority can also be achieved by leasing, however, this leaves a further puzzle: Why hasn’t the demand for a division of authority between common and separate functions been satisfied by leasing individual units in a rental complex? Why do we have common interest communities at all, given the leasing option?¹⁷

One possible explanation is tax law. The tenants in a leased residential complex cannot themselves deduct any portion of their rental payments against their income. In contrast, in a common interest community the owners of the individual units are allowed to deduct against income mortgage interest expense and the portion of their monthly assessments that reflects property taxes (subject to certain limits). Many real estate professionals believe that a significant part of the demand for housing in common interest communities is driven by these perceived tax advantages.

The matter is more complicated, however. Investors in rental properties can deduct mortgage interest payments and property taxes, and can also deduct other expenses, such as depreciation, that ordinary homeowners cannot. To the extent that the market for residential rental property is competitive, these tax deductions should be reflected in lower monthly rental payments, offsetting or perhaps exceeding the tax benefits from owning an individual unit.¹⁸ Furthermore, the use of common interest communities has spread to contexts such as gated communities of freestanding houses, where the use of the common interest community provides no tax advantage, because the individual units would almost certainly be owned rather than leased whether or not there is a common interest community. So in this context at least, taxes cannot explain the popularity of the common interest device.

Another explanation might be that people prefer to live in a selfgoverned community rather than in a community run by a dictator-landlord. It is undoubtedly true that some people are attracted by attending meetings of HOAs and serving on governing boards. But there is also significant anecdotal evidence that many people find these duties tiresome and are irritated by the often petty politics associated with disputes over assessment levels and pet policies.¹⁹ Given the difficulties of managing property by majority rule, the “transaction costs” of daily life in a common interest community are probably higher than in a rental community. Also, common interest communities can impose significant restraints on the ability of unit owners to exit, insofar as board approval is required for transfers of units (this is especially common with cooperative apartments). Thus, it is doubtful that governance advantages can account for the growing popularity of common interest communities, except perhaps for a subset of persons who find participatory governance structures a positive attraction.

A third explanation, which is consistent with the general theme of this chapter, is that, at least in the residential context, people increasingly find that common interest communities provide a better dividing line in the allocation of managerial authority between the common and separate facilities. We can call this the “designer kitchen” phenomenon. If the individual units in a residential complex are leased, then the tenants have general managerial authority over their individual units. They can decide what kind of furniture will be put in the unit, what the window treatments will look like, and of course they will have authority over who can enter the unit as a guest, whether the TV or the stereo is on at what hours, and so forth. But if the unit holders want to undertake a more dramatic change in the interior space, such as installing a designer kitchen, leasing presents problems. The landlord will be reluctant to pay for a designer kitchen, if the landlord has doubts about whether future tenants will be willing to pay higher rents to defray the costs of this improvement. The tenant will be reluctant to pay for the kitchen (assuming the landlord consents to this), because the improvements would be fixtures that would belong to the landlord when the lease terminates. So an individual who craves a designer kitchen will have difficulty getting one in a leased unit. (In many commercial tenancies, leases last much longer and each tenant is expected to remodel interior space according to its needs.)

In contrast, if the complex is organized as a common interest community, the designer kitchen presents few problems. The interior space is understood to be owned by the unit holder in fee simple. Thus, if the unit holder wants a designer kitchen, and is willing to pay for it, the unit holder can have the designer kitchen. The effect of the designer kitchen on the future value of the unit, for better or worse, will be borne entirely by the unit owner, not the other owners with interests in the complex. The point of course is not limited to designer kitchens, but applies also to remodeled bathrooms, tearing down or moving walls, combining two units into one, and so forth.

As society grows wealthier, and more people become interested in personalizing the space in which they spend their daily lives, more people will be interested in a property arrangement in which they have unilateral control over the design of their personal living space. If people also want the advantages of a division of managerial authority between common facilities and individual units, then common interest communities permit people to have the advantages of this division of authority, while also conferring a much stronger degree of individual control over interior spaces than is generally possible with leasing. This may be the best explanation for the growing popularity of common interest communities relative to leasing, given the weaknesses in the other explanations.

Trusts

Even more clearly than leasing and common interest communities, trusts are designed to separate management authority from other incidents of resources. Unlike leasing and common interest communities, trusts are typically not used to divide physical assets into common and separate components, with different management regimes devoted to each. Instead, trusts tend to be used for the management of assets held for investment purposes. Management of the assets is separated from the use and enjoyment of the income and capital gains generated by those assets, allowing different persons to manage and to consume the fruits of the assets. This arrangement is extremely useful. It is the principal mechanism today for managing the transmission of wealth within families. It is also widely used in the management of charitable foundations and nonprofit associations, in the organization of pension funds, and in the creation of certain kinds of investment vehicles.

The trust is one of the great inventions of English law (and the equity courts in particular), widely adopted or emulated by other legal systems. It involves three legal personas and some assets, sometimes called the trust res or corpus. The first persona is the settlor, who creates the trust out of assets that the settlor owns, typically in fee simple. The settlor makes a declaration, either by a deed of trust during the settlor’s life (an inter vivos trust) or by will (a testamentary trust), that the assets are subject to a trust. The declaration of trust conceptually splits the assets into two components, legal and equitable. Legal title to the trust assets is given to the second persona, the trustee, who typically retains possession of the assets and is charged with their protection and management. Equitable title to the trust assets belongs to the third persona, the beneficiary, who is entitled to enjoy the benefits of the trust corpus. Thus, once the trust takes effect, the trustee becomes the manager of the assets, while the beneficiary gets the beneficial use and enjoyment of the assets.

The different personas involved in the creation of a trust can be either natural or artificial persons (e.g., corporations). Corporate trustees are especially common. Most banks have trust departments, which specialize in the management of trusts. It is also possible for one person to function as more than one persona. The settlor can also be the trustee (if the settlor is still alive), and the trustee can also be a beneficiary. The only limit traditionally recognized is that one cannot create a trust in which one is both the sole trustee and the sole beneficiary.²⁰ But even this restraint is breaking down in some jurisdictions.

Trust law is the one area where the system of estates and future interests discussed in Chapter 5 continues to play an important role. Legal title to the trust assets is typically held by the trustee in fee simple. Hence the trustee can manage the property largely the way any owner of a fee simple could. The trustee can sell the property, use the proceeds to acquire different property, rent the property, use the property as collateral for a loan, and so forth. With respect to the equitable title of the beneficiaries, however, title is often divided. For example, there may be a surviving spouse, one or more children with spouses, and one or more grandchildren. Lawyers naturally looked to the system of estates in land to describe the different equitable interests of the different beneficiaries. Hence, beneficiaries will have equitable estates for life, equitable vested or contingent remainders, and occasionally equitable executory interests. Lawyers who practice trust law, at least in the context of family wealth transmission, need to be fluent in manipulating the categories of estates in land and future interests.

As in the case of leasing and common interest communities, contracts play a large role in the formation and implementation of trusts. The identity and duties of the trustee, the identity and interests of the beneficiaries, and the nature and extent of the trust property are all matters that can be spelled out in written agreements between the settlor and the trustee. These issues largely concern only the three personas involved in the trust—the settlor, the trustee, and the beneficiary—and do not affect the world at large. Most rules of trust law are therefore default rules that can be modified by contract.²¹

The principal exception to the purely contractual nature of the trust concerns the identity of the trust property, which can affect third parties, such as individual creditors of the trustee and the beneficiaries. In particular, it is important that the creditors of the trustee not be able to reach trust assets to satisfy the individual debts of the trustee. Trustees will also want assurances that creditors of the trust will not be able to reach the individual assets of the trustee to satisfy their claims. Consequently, for the trust to function properly, the trust assets must be sequestered from the other assets of the trustee.²² Title to the assets of the trust must be registered as trust property, and the trustee T must indicate whether T is acting in T’s capacity as trustee when T undertakes actions such as buying and selling securities for the trust. Also, owners of beneficial interests receive a degree of protection against transfers to third parties with notice of the trust.

Many trusts in the United States also have spendthrift clauses, meaning that creditors of the beneficiaries cannot reach the trust assets before they are distributed to the beneficiary. These clauses provide an additional reason why trust assets have to be sequestered and separately marked off from other assets of the trustee and the beneficiaries.

Much of trust law consists of an elaboration of what are called the fiduciary duties of trustees. These can be broadly subdivided into duties of loyalty, duties of impartiality, and duties of prudence. Duties of loyalty preclude trustees from self-dealing or engaging in transactions that create a conflict of interest with their obligations to the settlor and the beneficiaries. Duties of impartiality require that trustees act fairly toward all beneficiaries, not favoring one class of beneficiaries at the expense of others. Duties of prudence require that the trustee invest and manage the trust assets in a fashion that entails an appropriate degree of risk, given the circumstances of the beneficiaries and the nature of the trust property.

One interesting issue that arises in trust administration concerns the problem of changed circumstances not anticipated by the settlor. This is particularly an issue in the creation of charitable trusts, which can last for a very long time. Suppose, for example, the settlor leaves money in trust to create a foundation for the support of polio victims. Some years after the settlor dies, Dr. Jonas Salk develops the polio vaccine, with the result that over time there are progressively fewer victims of the disease who need support. Must the trustee continue to use the trust funds for the support of diminishing numbers of polio victims, or can the trustee seek to have the trust modified to devote the funds to some other purpose? This question is governed by the cy pres doctrine (“cy pres” is Norman French for “so close” or “as close”), which permits courts in some circumstances to revise trusts in light of changed circumstances. American courts, reacting to abuses of cy pres doctrine by English courts, initially applied a very restrictive version of the doctrine. They required that the specific charitable purpose be impossible or illegal, and that the instrument of trust reflect a “general charitable intent” in addition to the specific purpose. More recently, courts have become more willing to invoke the doctrine, with the Restatement of the Law Third, Trusts going so far as to say that cy pres should be available when carrying out the original trust would be “wasteful.”²³

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